Schwab offers first all-ETF 401(k) plan

Charles Schwab on Wednesday launched the first 401(k) plan that will have exchange-traded funds as the only investment option and let employees trade them throughout the day.

The low-cost plan will let employers choose from about 80 ETFs offered by 11 different vendors, including iShares, State Street Global Advisors, Vanguard and Charles Schwab Investment Management.

ETFs are mutual funds, primarily index funds, that trade throughout the day on a stock exchange, like individual stocks. Traditional mutual funds can only be bought and sold at the end of day at one price.

In addition to all-day trading, ETFs have several advantages over traditional funds: they are slightly more tax efficient and they offer more access to niche asset classes such as foreign real estate, gold, emerging markets bonds or clean-energy companies.

But it’s not clear whether employers want employees day trading their 401(k) account or buying esoteric funds. And the tax advantage of ETFs “totally doesn’t matter in a 401(k) plan” because it is tax deferred, says Jon Chambers, a pension fund consultant with Schultz Collins Lawson Chambers.

“The advantages of ETFs are pretty much useless in the 401(k) world,” he says.

Schwab apparently doesn’t think so. It has invested a lot of time and money into overcoming the technical and regulatory hurdles of using ETFs in a 401(k) plan. One is the fractional share problem.

Traditional mutual funds trade in fractional shares, so employees can contribute a fixed dollar amount — such as $100 per week— and have it invested in one or more funds no matter what their price. They would end up with whole and partial shares.

But ETFs do not trade in fractional shares. Schwab has solved the problem by having its brokerage firm hold the fractional shares.

TD Ameritrade, a much smaller player in the retirement-plan market, has been letting employers offer ETFs as an option in 401(k) plans for almost three years, but it does not offer an all-ETF plan. Nor does it allow intra-day trading of ETFs; employees can only trade them at the end of the day at the closing price. That reduces the trading fees associated with executing lots of small ETF trades.

Schwab will let employees trade ETFs during the day and will not charge them brokerage commissions.

Schwab says its new ETF plan will be cheaper than 401(k) plans using traditional mutual funds, even ones that use all index funds.

A typical plan that uses traditional actively managed funds might have investment fees of 0.65 to 0.75 percent of assets per year.

The Schwab Index Advantage plan, a 401(k) platform introduced two years ago that offers all index funds, has investment fees of about 0.15 percent.

“We think we can we can take that to (0.10 percent) with ETFs, in some cases in the low single digits,” says Steve Anderson, head of Schwab Retirement Plan Services.

Most employees, however, will pay more because the plan will come packaged with a 401(k) advice service from Guided Choice or Morningstar. These services automatically invest an employees’ account in a mix of funds based on information from their paycheck, such as their age, salary, gender, salary and savings rate. The account is rebalanced every quarter to maintain a desired ratio of stocks and bonds. Employees can also have a one-hour chat about their account with a Schwab employee.

This service costs about 0.35 to 0.45 percent of assets per year, which brings the total account cost to about 0.50 percent — still less than the cost of a traditional 401(k) plan without advice, Anderson says.

Employees can opt out of the advice service and save the additional fee, but Schwab says about 85 percent of employees who are offered advice take it.

The new account will park cash balances in Schwab Bank rather than a stable value or money market fund. Another advantage of the plan is that it will have no hidden fees, which have become common in 401(k) plans.

Schwab will make money when employees hold balances in Schwab Bank or in one of Schwab’s proprietary ETFs. Schwab will also get a cut of the advice fees.

About 11 percent of employers who offer a 401(k) plan through TD Ameritrade have chosen to add ETFs. Although they make up only 4 percent of assets in all TD Ameritrade-run plans, among the 11 percent of plans that offer them, they make up about half of plan assets, says Skip Schweiss, president of TD Ameritrade Trust Co.

“I don’t know if this will be a big product or a little product,” for Schwab, says Richard Repetto, an analyst with Sandler O’Neill & Partners. But as a Top 10 recordkeeper with a history of innovation, it’s something the industry will be watching closely.